Key points covered in this article:

  • Capitalized interest, which adds loan interest to project costs instead of immediate deduction, can significantly impact cash flow for small and mid-size contractors, especially with rising interest rates and longer project timelines.
  • Smaller contractors may qualify for exceptions to capitalize interest if their contracts meet specific IRS criteria, such as shorter project durations and lower gross receipts.
  • Effective planning, including clear record-keeping, cash flow projections, and strategic financing, can help contractors manage the challenges of capitalized interest.

It is time to start paying attention to capitalized interest. For construction companies, this means recognizing that interest on a construction loan is often added to project cost and deducted much later, when the project is sold or placed in service. The timing can have a big impact on cash flow during the build, especially for small and mid-size contractors.

This matters even more now because financing costs are higher and projects are taking longer to finish, so loans stay outstanding and interest keeps accruing. In many situations the rules require capitalization, though limited relief may apply for smaller contractors. Companies will want to understand when the rules apply, where current expensing may still be available, and how to set methods and cash flow plans that fit today’s conditions.

Understanding Capitalized Interest

When a business pays interest on a loan, the usual expectation is that the expense is deducted immediately. Construction usually follows a different set of rules. If the loan is tied to building a project, the tax rules require the interest to be added to the cost of that project. This practice is called capitalizing interest.

The reasoning behind the rule is that all costs connected to a project should be grouped together until the project generates income. Materials, labor, and overhead are treated this way, and the IRS includes interest in that list. That requirement comes from Section 263A of the Internal Revenue Code, commonly called the uniform capitalization or UNICAP rules.

For example, a contractor borrows $500,000 to finance a residential build. Over the course of the year, the contactor pays $25,000 in interest. If that interest could be expensed, taxable income would fall by $25,000 this year. Because the rules require it to be capitalized, the $25,000 is added to the cost of the project and the deduction does not arrive until the homes are sold. The contractor eventually deducts the full amount, but the timing difference creates a potential cash flow issue for businesses that rely on short-term tax savings.

There is an exception for some smaller contractors. To qualify, a contractor must generally meet two tests: 1) the contract is expected to be completed within two years, and 2) average annual gross receipts for the prior three years fall below the IRS threshold. That threshold was $31 million in 2025, with adjustments made each year for inflation. Contractors that meet both tests may use more favorable methods and expense interest when paid. Once receipts exceed the limit, the capitalization rules apply.

It is also possible for companies to choose to capitalize interest voluntarily. Doing so can make financial statements look stronger because expenses appear lower during the build phase. The trade-off is that voluntary capitalization may limit deductions under Section 163(j). Contractors who are not aware of this connection can face unintended tax consequences.

Why It Is More Relevant Today

The rules on capitalized interest have been in place for years. What has changed is the economic environment.

Interest rates are higher than they have been in recent memory, which means the dollar value of capitalized interest is larger. Projects are also lasting longer, which increases the amount of interest tied up on the balance sheet before it can be deducted. Margins for many contractors remain thin, so losing the ability to take immediate deductions makes it harder to manage operating costs.

For larger companies, these timing issues are easier to absorb. Smaller contractors feel the impact more directly because they depend on every available dollar to manage payroll, materials, and new bids. The combination of higher borrowing costs and delayed deductions has turned what once felt like a technical detail into an everyday business concern.

Strategies for Contractors

Small and mid-size contractors are still subject to the capitalization rules, but the effect can be managed with the right planning. A few steps are especially useful:

  • Maintain records that clearly separate loan interest tied to specific projects from other financing costs. This makes it easier to classify interest correctly for both tax and financial reporting.
  • Build cash flow projections that account for the delay in deductions, so there are no surprises when tax season arrives.
  • Review financing and loan terms regularly. Some contractors lower interest costs just by refinancing or changing the structure.
  • Consider how capitalization affects both financial reporting and tax planning. What works for one purpose may create challenges for the other.
  • Consult with advisors before making any moves, especially when capitalizing interest voluntarily.

Conclusion

Capitalized interest does not change whether a contractor can deduct interest, but it does change when. For small and mid-size firms, contractors that understand the rules and planning ahead are in a better position to manage liquidity, meet obligations, and keep work moving forward. For more information, contact Jennifer French, Partner on PBMares’ Construction & Real Estate team.